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CHAPTER
24 In this chapter,
look for the answers to these questions:
▪ What is the Consumer Price Index (CPI)?
Measuring the Cost of Living How is it calculated? What’s it used for?
▪ What are the problems with the CPI? How serious
Economics
PRINCIPLES OF
are they?

N. Gregory Mankiw ▪ How does the CPI differ from the GDP deflator?
▪ How can we use the CPI to compare dollar
amounts from different years? Why would we want
Premium PowerPoint Slides to do this, anyway?
by Ron Cronovich
▪ How can we correct interest rates for inflation?
© 2009 South-Western, a part of Cengage Learning, all rights reserved 1

0 1

The Consumer Price Index (CPI) How the CPI Is Calculated

▪ measures the typical consumer’s cost of living 1. Fix the “basket.”
The Bureau of Labor Statistics (BLS) surveys
▪ the basis of cost of living adjustments (COLAs) in
consumers to determine what’s in the typical
many contracts and in Social Security
consumer’s “shopping basket.”
2. Find the prices.
The BLS collects data on the prices of all the
goods in the basket.
3. Compute the basket’s cost.
Use the prices to compute the total cost of the
basket.

MEASURING THE COST OF LIVING 2 MEASURING THE COST OF LIVING 3

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How the CPI Is Calculated EXAMPLE basket: {4 pizzas, 10 lattes}

4. Choose a base year and compute the index. price of price of

year cost of basket
The CPI in any year equals pizza latte
2007 $10 $2.00 $10 x 4 + $2 x 10 = $60
cost of basket in current year
100 x 2008 $11 $2.50 $11 x 4 + $2.5 x 10 = $69
cost of basket in base year
2009 $12 $3.00 $12 x 4 + $3 x 10 = $78
5. Compute the inflation rate. Compute CPI in each year usingInflation
2007 base
rate:year:
The percentage change in the CPI from the
2007: 100 x ($60/$60) = 100 115 – 100
preceding period. 15% = x 100%
100
2008: 100 x ($69/$60) = 115
Inflation CPI this year – CPI last year 130 – 115
= x 100% 2009: 100 x ($78/$60) = 130
13% = x 100%
rate CPI last year 115

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ACTIVE LEARNING 1 ACTIVE LEARNING 1

Calculate the CPI Answers
price price of price price of
CPI basket: of beef chicken CPI basket: of beef chicken
{10 lbs beef, {10 lbs beef,
2004 $4 $4 2004 $4 $4
20 lbs chicken} 20 lbs chicken}
2005 $5 $5 2005 $5 $5
The CPI basket cost $120 The CPI basket cost $120
in 2004, the base year. 2006 $9 $6 in 2004, the base year. 2006 $9 $6

A. Compute the CPI in 2005. A. Compute the CPI in 2005:

B. What was the CPI inflation rate from 2005-2006? Cost of CPI basket in 2005
= ($5 x 10) + ($5 x 20) = $150

CPI in 2005 = 100 x ($150/$120) = 125

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ACTIVE LEARNING 1 What’s in the CPI’s Basket?

Answers
price price of 4% 3% Housing
CPI basket: of beef chicken 6%
{10 lbs beef, Transportation
2004 $4 $4 6%
20 lbs chicken} Food & Beverages
2005 $5 $5 43%
The CPI basket cost $120 6%
Medical care
in 2004, the base year. 2006 $9 $6
Recreation
B. What was the inflation rate from 2005-2006?
Education and
Cost of CPI basket in 2006 15%
communication
= ($9 x 10) + ($6 x 20) = $210 Apparel

CPI in 2006 = 100 x ($210/$120) = 175 17% Other

CPI inflation rate = (175 – 125)/125 = 40%
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ACTIVE LEARNING 2 ACTIVE LEARNING 2

Substitution bias Answers
CPI basket: cost of CPI CPI basket: cost of CPI
{10# beef, beef chicken {10# beef, beef chicken
basket basket
20# chicken} 20# chicken}
2004 $4 $4 $120 2004 $4 $4 $120
2004-5: Household
2005 $5 $5 $150 2005 $5 $5 $150
Households basket in 2006:
2006 $9 $6 $210 {5# beef, 2006 $9 $6 $210
bought CPI basket.
25# chicken}
2006: Households bought {5 lbs beef, 25 lbs chicken}.
A. Compute cost of the 2006 household basket.
A. Compute cost of the 2006 household basket.
($9 x 5) + ($6 x 25) = $195
B. Compute % increase in cost of household basket
over 2005-6, compare to CPI inflation rate.
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ACTIVE LEARNING 2 Problems with the CPI:

Answers Substitution Bias
CPI basket: cost of CPI ▪ Over time, some prices rise faster than others.
{10# beef, beef chicken
basket
20# chicken} ▪ Consumers substitute toward goods that become
2004 $4 $4 $120 relatively cheaper.
Household
2005 $5 $5 $150
basket in 2006: ▪ The CPI misses this substitution because it uses
{5# beef, 2006 $9 $6 $210
a fixed basket of goods.
25# chicken}
▪ Thus, the CPI overstates increases in the cost of
B. Compute % increase in cost of household basket living.
over 2005-6, compare to CPI inflation rate.
Rate of increase: ($195 – $150)/$150 = 30%
CPI inflation rate from previous problem = 40%
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Problems with the CPI: Problems with the CPI:

Introduction of New Goods
▪ The introduction of new goods increases variety,
allows consumers to find products that more
closely meet their needs.
▪ In effect, dollars become more valuable.
▪ The CPI misses this effect because it uses a
fixed basket of goods.
▪ Thus, the CPI overstates increases in the cost of
living.
Unmeasured Quality Change
▪ Improvements in the quality of goods in the
basket increase the value of each dollar.
▪ The BLS tries to account for quality changes
but probably misses some, as quality is hard to
measure.
▪ Thus, the CPI overstates increases in the cost of
living.

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Problems with the CPI Two Measures of Inflation, 1950-2007

▪ Each of these problems causes the CPI to Percent
15
overstate cost of living increases. per Year

▪ The BLS has made technical adjustments, 10

but the CPI probably still overstates inflation
by about 0.5 percent per year. 5

▪ This is important because Social Security

payments and many contracts have COLAs tied 0

to the CPI.
-5
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
CPI GDP deflator

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Contrasting the CPI and GDP Deflator ACTIVE LEARNING 3

Imported consumer goods:
CPI vs. GDP deflator
▪ included in CPI In each scenario, determine the effects on the
▪ excluded from GDP deflator CPI and the GDP deflator.
Capital goods: A. Starbucks raises the price of Frappuccinos.
▪ excluded from CPI
▪ included in GDP deflator B. Caterpillar raises the price of the industrial
The basket: tractors it manufactures at its Illinois factory.
(if produced domestically)
▪ CPI uses fixed basket
▪ GDP deflator uses basket of C. Armani raises the price of the Italian jeans it
currently produced goods & services sells in the U.S.
This matters if different prices are
changing by different amounts.

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ACTIVE LEARNING 3 Correcting Variables for Inflation:

Answers Comparing Dollar Figures from Different Times

A. Starbucks raises the price of Frappuccinos.

▪ Inflation makes it harder to compare dollar
amounts from different times.
The CPI and GDP deflator both rise.
▪ Example: the minimum wage
B. Caterpillar raises the price of the industrial ▪ $1.15 in Dec 1964
tractors it manufactures at its Illinois factory. ▪ $5.85 in Dec 2007
The GDP deflator rises, the CPI does not. ▪ Did min wage have more purchasing power in
C. Armani raises the price of the Italian jeans it
Dec 1964 or Dec 2007?
sells in the U.S. ▪ To compare, use CPI to convert 1964 figure into
The CPI rises, the GDP deflator does not. “today’s dollars”…

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Correcting Variables for Inflation: Correcting Variables for Inflation:

Comparing Dollar Figures from Different Times Comparing Dollar Figures from Different Times
Amount Amount Price level today
▪ Researchers, business analysts and policymakers
in today’s = in year T x often use this technique to convert a time series of
dollars dollars Price level in year T current-dollar (nominal) figures into constant-dollar
▪ In our example, (real) figures.
▪ year T = 12/1964, “today” = 12/2007 ▪ They can then see how a variable has changed
▪ Min wage = $1.15 in year T over time after correcting for inflation.
▪ CPI = 31.3 in year T, CPI = 211.7 today ▪ Example: the minimum wage, from Jan 1950 to
The minimum wage
Dec 2007…
211.7
in 1964 was $7.78 $7.78 = $1.15 x
31.3
in today’s (2007) dollars.
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The U.S. Minimum Wage in Current Dollars

ACTIVE LEARNING 4
and Today’s Dollars, 1950-2007
$9
Converting to “today’s dollars”
$8 2007 dollars Annual tuition and fees, average of all public four-
$ per hour

year colleges & universities in the U.S.

$7

$6
▪ 1986-87: $1,414 (1986 CPI = 109.6)
$5
▪ 2006-07: $5,834 (2006 CPI = 203.8)
$4 After adjusting for inflation, did students pay more for
college in 1986 or in 2006? Convert the 1986 figure
$3
to 2006 dollars and compare.
$2 current dollars
$1

$0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 25

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ACTIVE LEARNING 4 Correcting Variables for Inflation:

Answers Indexation
Annual tuition and fees, average of all public four- A dollar amount is indexed for inflation
year colleges & universities in the U.S. if it is automatically corrected for inflation
▪ 1986-87: $1,414 (1986 CPI = 109.6) by law or in a contract.
▪ 2006-07: $5,834 (2006 CPI = 203.8)
For example, the increase in the CPI automatically
Solution determines
Convert 1986 figure into “today’s dollars” ▪ the COLA in many multi-year labor contracts
$1,414 x (203.8/109.6) = $2,629 ▪ the adjustments in Social Security payments
Even after correcting for inflation, tuition and fees and federal income tax brackets
were much lower in 1986 than in 2006!
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Correcting Variables for Inflation: Correcting Variables for Inflation:

Real vs. Nominal Interest Rates Real vs. Nominal Interest Rates
The nominal interest rate: Example:
▪ the interest rate not corrected for inflation
▪ Deposit $1,000 for one year.
▪ the rate of growth in the dollar value of a
deposit or debt ▪ Nominal interest rate is 9%.
▪ During that year, inflation is 3.5%.
The real interest rate:
▪ corrected for inflation ▪ Real interest rate
= Nominal interest rate – Inflation
▪ the rate of growth in the purchasing power of a
= 9.0% – 3.5% = 5.5%
deposit or debt
▪ The purchasing power of the $1000 deposit
Real interest rate has grown 5.5%.
= (nominal interest rate) – (inflation rate)
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Real and Nominal Interest Rates in the U.S., CHAPTER SUMMARY

1950-2007

15
▪ The Consumer Price Index is a measure of the
(percent per year)

10
Interest Rates

cost of living. The CPI tracks the cost of the typical

5 consumer’s “basket” of goods & services.

0 ▪ The CPI is used to make Cost of Living

Adjustments and to correct economic variables for
-5
the effects of inflation.
-10 ▪ The real interest rate is corrected for inflation
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
and is computed by subtracting the inflation rate
Nominal interest rate Real interest rate
from the nominal interest rate.
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